Category Archives: hedging

A key challenge in executing a sensible hedging strategy is the inevitable second guessing that happens with the benefit of 20-20 hindsight. Whenever a hedge loses money, outsiders question how much more profitable the company could have been without the hedge. Comparisons are made against competitors that did not hedge, and so performed better. No matter that the hedge accomplishes its objective—reducing volatility. When that reduced volatility is windfall profits foregone, the carping begins.

Last week, American Airlines was the last of the major U.S. airlines to report its 2014 financial results, and every airline was announcing improved operating cash flow due to the huge drop in jet fuel prices. Since American does not hedge, analysts were quick to announce that “they have won big time.”

Airlines that do hedge, have had to report losses on their hedge positions. Delta’s 4th quarter announcement revealed more than $1 billion in charges due to mark-to-market adjustments on its fuel hedges. The losses on hedges offset some of the benefits the airlines are capturing from the drop in fuel prices. If they hadn’t hedged, shareholders would have seen a larger gain from the drop in fuel prices. That puts pressure on management to get rid of the hedging program.

Southwest Airlines announced that it had eliminated its hedge on 2015 prices, so if the oil price drops any further, all of that will drop to its bottom line. It also reduced the scale of its hedging in 2016, 2017 and 2018.

Does it make sense to eliminate the hedge? Is this a case of trend following—having missed the initial decline, the company hopes to catch the next decline? Is this a case of not standing by a well thought through strategy when short-term events fail to go your way? These are real problems in executing a hedging strategy.

A case can be made for adjusting the hedge ratios in response to the fall in price. After all, as Southwest’s executives explained, the purpose of hedging is to provide “catastrophic protection”, meaning against sky high jet fuel prices. With prices as far down as they are, we’re far away from catastrophe. If prices start back up, and if the company is nimble, there will be time to insure against catastrophe.

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ISDA, the trade association for OTC derivatives, released a paper today purporting to document the dangers of derivatives reform. As usual, the alleged victims are ‘end-users’, the non-financial firms using derivatives to hedge risk. The paper is organized around 4 case studies of firms and their OTC derivative hedges, and makes specific claims about their specific hedges. This is a refreshing change from the usual vague generalities, so it is worthwhile examining those claims in some detail. Moreover, ISDA hired two accomplished finance professors to author and lend their credentials to the paper, so there is a promise that the arguments will have more substance than the usual lobbying pitches.

Unfortunately, the promise of something new is unfulfilled. The paper repackages old, debunked claims. Its arguments are shallow and unpersuasive.

Take as an example the case of the chemical company, FMC, and its hedge of natural gas prices. Although the abstract says that the authors will examine hedge effectiveness, the accounting treatment and the impact on earnings per share, in fact, the paper does none of those things. Instead, it makes two other points which I will examine in turn.

First, the ISDA paper claims that the reform increases FMC’s administrative burden of hedging. How? By forcing FMC out of the OTC derivative market and into exchange traded futures. It takes a cumbersome assemblage of 13 futures to reproduce what can be done with 1 OTC swap. The paper implies that managing this cumbersome assemblage is costly, although it never really accepts the burden of quantifying the extra cost.

This argument does not stand up to scrutiny. The whole premise is wrong. The reform does not prohibit FMC from using OTC swaps instead of futures. So why is the comparison of 13 futures to 1 OTC swap relevant? The paper never explains the premise. It’s just implicit in the comparison of the burden of managing an OTC swap against managing a package of futures. Moreover, suppose we imagine that the OTC market was outlawed. Even then, there is nothing in FMC’s customized swap that cannot be reproduced in the futures market. Clearly the risk profile can be perfectly reproduced, as the package of 13 futures demonstrates. So the only problem we are left with is the administrative burden. FMC cannot handle the 13 contracts itself in house. That’s why it’s dealer constructed a packaged swap. But our imaginary prohibition of the OTC market doesn’t outlaw all forms of financial services. FMC’s banker is free to offer the service of managing a package of 13 futures which replicates FMC’s desired risk profile. In fact, that’s exactly what FMC was getting from its OTC derivative dealer. And you can be sure that FMC paid for that service, although the paper’s authors conveniently overlooked the price charged. There is absolutely nothing in the derivatives reform that stops FMC from outsourcing the management of its natural gas exposure using futures contracts. And there is absolutely nothing in the ISDA paper to suggest that it is more costly for the finance industry to provide that service using futures contracts.

Second, the ISDA paper claims that the reform increases the amount of margin FMC must post, and the paper calculates the margin on FMC’s natural gas hedge. The paper implies that this extra margin is an extra cost. This assumes a false equality between margin paid and cost incurred. An OTC derivative saves FMC the burden of paying margin only by having the dealer extend FMC credit. You can be sure that FMC is charged for that service. Unfortunately, the ISDA paper completely overlooks the price paid for credit risk. My paper on “Margins, Liquidity and the Cost of Hedging,” with my colleague Antonio Mello, shows that when you take into account credit risk, FMC’s costs are exactly the same whether they use the non-margined OTC swap or a fully margined futures package.

The Wall Street Journal ran a story last week about Citigroup and Deutsche losing money on the oil hedge they sold to Mexico. The article talks of a loss totaling $5 million on a put sold for a premium of $450 million, so, in the grand scheme of things, this is not a big matter. However, it does raise an interesting puzzle in light of the Volcker Rule’s prohibition against proprietary trading.

Matt Levine over at Bloomberg does a nice job of dissecting what the banks are doing in the deals with Mexico. It’s part intermediation – taking a portion of the oil price risk from Mexico and reselling it through the oil futures market. But it’s also part acting as a principal – taking another portion of the oil price risk from Mexico and putting it onto their own balance sheets.

Are they allowed to do that – put the oil price risk onto their balance sheet? How is that different from proprietary trading? If Mexico weren’t involved, and the other side of the trade were a hedge fund, would that be any different, as far as safety and soundness is concerned?

Matt Levine thinks the story is a nice example of the banks doing their job. Sure enough, it’s a job that needs being done. But is it really the job of the banks to warehouse oil price risk? It may be socially useful, it may be a valuable financial activity, but it’s not an activity that belongs on a bank balance sheet. Levine’s column reflects how hard it is to get away from the old mentality in which banks think their job is to sell their balance sheet. The problem is, of course, that it isn’t their balance sheet that they are selling. It’s the taxpayers’.

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What happens when you sell your customers power at a fixed price, and you buy your power at a floating price? A local DC green electricity marketer, Clean-Currents, found out as last month’s frigid temperatures sent wholesale power prices rocketing. It’s now out of business, and the customers who had those contracts are…back on the market either getting their power from the incumbent utility or looking for a fresh deal.

Clean-Currents sent this message to customers:

Dear Customers:

We are writing to inform you, with deep regret, that the recent extreme weather, which sent the wholesale electricity market into unchartered territories, has fatally compromised our ability to continue to serve customers.

We are extremely saddened to share this news with you.

What does this mean for you?

All Clean Currents’ customers will be returned to their utility service, effective immediately. You should see this change in service on your next bill, or the bill after that, dependent on your meter read cycle. If you so choose, you are able to switch to another third party electricity supplier, effective immediately. Clean Currents waives any advanced notice requirement or early termination fee provisions in our contracts.

Please contact your utility if you have any questions about your change in service: …

We are deeply grateful that you chose to be a Clean Currents customer. It has been a pleasure to serve you. We hope you will still choose renewable energy for your home or business.Sincerely,

Gary Skulnik & Charles Segerman, Clean Currents Co-Founders

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On its quarterly earnings call earlier this week, the new American Airlines confirmed speculation that it would end the company’s legacy policy of hedging jet fuel prices. The hedges that are in place will be allowed to runoff, but they will not be replaced.

American’s merger with US Airways was completed in December, and the combined company is being led by US Airways’ management team. For a number of years now, since 2008, US Airways has shunned hedging. Now that policy is being extended to the merged firm.

Why?

Experience is one factor. Going into 2008, US Airways hedged jet fuel prices just like other companies. But 2008 was a wild ride for all businesses in which fuel costs are a major line item, airlines especially. Oil prices spiked dramatically during the first half of the year, and then collapsed even more dramatically during the second half. While the company may have profited off of its hedges in the first two quarters, it reported whopping losses on its hedges in the last two–$488 million in the 3rd quarter and another $234 in the 4th quarter, each time approximately half the company’s total loss in the quarter. Of course, at the same time the airline was paying a smaller price to buy jet fuel, so the company’s net cash flow on fuel plus the hedge showed less volatility. That’s how a hedge is supposed to work. But hedge decisions are always second guessed whenever the financial leg of the package earns a loss.

The second guessing at US Airways goes a little deeper than usual, and the management team’s rationale deserves a fair hearing.

Management seems to think that hedging somehow invites companies to be less ruthless about cost discipline. At it’s Q2 earnings call last year, US Airways President Scott Kirby said

And our cost discipline has been equally impressive. First, since US Airways stopped hedging fuel we’ve had the lowest or second lowest cost of fuel in 10 of the last 14 quarters, a strong validation of our no hedging strategy.

Management also thinks it isn’t really as exposed to fuel costs as many imagine. Casual observers focus too narrowly on jet fuel costs alone, the company points out. Looking at operating margin – revenue less variable cost – the company has a much smaller exposure to jet fuel prices than first meets the eye. Here’s Scott Kirby again, from a 2012 conference:

I think a non-fuel hedging program is the most effective and the most rational program because we have a natural hedge. This is a natural hedge — fuel prices versus demand. When fuel prices are going up, in most cases revenue is going to follow and vice-versa. Fuel prices are driven in many regards by the economy. That’s not the only driver of fuel prices, but it’s probably — over a longer time horizon, it is the principal driver of fuel prices as what’s happening with the economy, and so we have a strong natural hedge. And if we hedge jet fuel prices or hedge oil prices, you’re breaking this natural hedge, not to mention the expense of hedging but just the natural hedge that you have between jet fuel and revenues.

So a sizable financial hedge is not necessary, and might even increase the airline’s risk.

I have a hard time believing that the right hedge is zero. Ticket prices don’t move one-for-one with jet fuel prices, at least not immediately. Many tickets are sold in advance, whether individually or as a part of corporate and other packaged sales. And the quantity of sales will be affected by the price, too, so that the company is exposed on an aggregate basis even when its operating margin is not.

Of course, that argument does not take into account the cost of hedging. In order to cover those costs, Kirby said, fuel prices would have to rise 30% year-over-year, something he obviously doesn’t think is likely.

Since US Airways inaugurated its new policy of not hedging, oil prices have stayed in a relatively narrow band, so the policy has not yet been stress tested. Now that policy is being extended to the larger, combined American Airlines. It will be interesting to see whether it runs into any stormy price swings, and how it fares under stress.

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During last year’s debate about the Volcker Rule, Morgan Stanley commissioned a study by the consulting firm IHS that predicted dire consequences for the U.S. economy. I called the study a hatchet job. My main complaint was that the study made the obviously unreasonable assumption that the bank commodity trading operations would be closed down and not replaced. IHS even excluded the option of having banks sell the operations.

US private equity group Riverstone is leading talks on an investment of as much as $1bn in a new commodities investment venture to be run by a former Deutsche Bank executive…

Morgan Stanley is considering a sale or a joint venture for its commodities business… James Gorman, Morgan Stanley’s chief executive, last October said the bank was exploring “all form of structures” for its commodities business.

Glenn Dubin, Paul Tudor Jones and a group of other commodity hedge fund investors last year bought the energy trading business from Louis Dreyfus Group and Highbridge Capital, the hedge fund owned by JPMorgan Chase. The parties later renamed the business Castleton Commodities International.

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Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.

Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.

As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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About this blog

We use this blog to discuss with our students issues in risk management for non-financial corporations. The blog addresses interesting events in the news, as well as advances in financial analysis. We have made the blog public to encourage valuable contributions from former students, colleagues and others in industry, government and academia.

The content of the blog is closely aligned with the material in our lecture notes on Advanced Corporate Risk Management (MIT course 15.423). A website with the notes and associated materials will be coming soon.